Why TVL is important and how to calculate it correctly

We explain the importance of the TVL indicator and how to calculate it correctly. And how to use it to assess the investment case for blockchain projects

Total value locked (TVL) is one of the key metrics. It helps to understand the value of a blockchain-based service, protocol or application. The use of smart software contracts in such applications is rethinking traditional financial solutions by automating contractual logic. And it does not require an intermediary in the form of the usual financial institutions (banks, exchanges or others).

Smart contracts enable the development of decentralised finance (DeFi). The transparency of the blockchain as a public registry of transactions makes it possible to see the volume of funds. This can be seen both in an individual smart contract and in an entire ecosystem of blockchain-based applications, such as Ethereum. TVL is a key metric for demonstrating audience interest in a particular protocol. And it is commonly referred to as a decentralized application (dApp).

How TVL is calculated

Uniswap, one of the largest decentralised exchanges (DEX), is a case in point. It pioneered the development of automated market makers (AMMs). And it has made it possible for users to exchange tokens without the need for intermediaries.

Anyone can deposit funds into Uniswap liquidity pools representing paired tokens. Pools for paired tokens, such as ETH/USDT, lock in users’ funds. And in doing so, turning those users into liquidity providers (LPs). When other traders want to exchange a token (USDT or ETH), they connect to the appropriate pool to take advantage of its liquidity. The liquidity providers, in turn, receive a percentage of the token conversion.

Each liquidity pool has its own TVL, which shows how much total cryptocurrency funds in dollar terms have entered the pool. If you take the total amount of funds in each pool on Uniswap. You can then determine the total liquidity of the exchange. Similarly, all liquidity pools of other networks, remembering Ethereum, that Uniswap also supports – Arbitrum, Polygon, Optimism, Celo and others. As of early July, the total value of all blockchain tokens in all Uniswap pools is $4.11 billion, according to the DefiLlama service.

A similar process for calculating TVL can be applied to credit protocols such as Aave or Curve. This is because they use the same principle of pooling the liquidity of smart contracts. However, TVL does not take into account outstanding loans and yields. And which liquidity providers’ deposits earn. Instead, TVL only reflects the value of smart contract deposits. If you calculate TVL not at a specific protocol. But for example the entire blockchain network (e.g. Ethereum), it would take into account the total TVL of all applications. As of July, the TVL of all dApps on the Ethereum network is $26.77 billion – about 60% of the entire DeFi market.

Why TVL matters

TVL clearly shows the value of deposits and people’s interest in a particular protocol or blockchain network. Similarly, when more deposits are made to one bank than another, it indicates that the first bank is more popular.

In addition, TVL allows for an assessment of the overall health of a particular protocol. If it holds more funds. It means it has higher liquidity and can operate more efficiently. Because in decentralised finance, the liquidity providers are the users themselves. This is critical for the sustainability of the market. Lack of liquidity leads to significant delays and higher token exchange fees.

Moreover, significant demand or an attempt to exchange too much money on a decentralised exchange can cause fluctuations in token prices. And that will lead to failed transactions. This is why the liquidity pools have a slippage percentage for each pair of tokens. If, for example, the price of a token rises above 0.3% during an exchange, the transaction is cancelled.

A lower TVL in a dApp or blockchain means less monetary stability. This can lead to lower rewards for liquidity providers. And a deterioration in the overall state of the protocol.

How reliable is the information on TVL

If the market capitalisation of a dApp is greater than its TVL, the protocol is said to be overvalued. At the same time, if you divide the amount of capitalisation of a protocol by the amount of its TVL. And the ratio will be less than one, we can say that the protocol is undervalued. That said, the ratio of market capitalisation to TVL for DeFi services is often dynamic.

The market capitalisation depends on the price of the service’s native token multiplied by its total negotiable supply. For the Uniswap protocol, this token is the UNI control token. Its price is usually influenced by market hype, the listing of the token on exchanges. As well as protocol updates and other significant events.

Another factor that can distort TVL as an indicator of project value is the activity of so-called whales. These are investors or organisations that have significant capital at their disposal in crypto-assets. They are capable of increasing a project’s TVL with just one large deposit. Or conversely, collapse it if they decide to withdraw assets from the pools.

Our experts point out that it is worth paying attention to the total number of users of the protocol or blockchain in this regard.